Saturday, September 20, 2008

Tired of Crises? Try Free Markets and Correct Incentives this Time

To start, let's keep in mind that no realistic economic system will ever be able to avoid economic crises. Crises are a natural part of a vigorous economy. If you are adamant about not getting the flu, try never having been born.

Now that we agreed that crises are unavoidable, let's think about how to make them less frequent and intense. Let's use as a guide the core principle of economics that incentives matter. Incentives in the financial markets have taken too much abuse and mistreatment for too many decades. Shouldn't we try to get the incentives right this time?

Financial markets have always been hampered by badly designed regulations and counterproductive government bodies. Brooks and Baker (HT Mankiw), among others cited in this blog, describe the problem in depth, explaining how bad incentives and government failures created another financial crisis. More of the same old poison will only make it anew. Give free markets a chance, make sure that regulations don't distort incentive mechanisms, and impose them on the markets only when benefits are greater than costs.

And let's not heed the millenarians and doomsday prophets. In moments of crisis, they rise like the phoenix from the ashes of failed ideologies. They will try to use the opportunity to restrict our freedoms and distort incentives once again, for their own benefit. Let's not allow them to sow the seeds of the next crisis this time.

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